BFM 423 Financial Modelling AND Forecasting PDF

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D EPARTM EN T OF BU SI N ESS AN D PU BLI CM ANAGEM ENTCO U RSE COD E: BFM 4 2 3CO U RSE TI TLE: FI NAN CI AL M O D ELLI N G AN DFORECASTI NGI n st r u ct i on a l M a t er i a l for BFM - D i st a n ceLea r n i n g......BFM 423: FINANCIAL MODELLING AND FORECASTINGPre-requisites: BFM 312Purpose: To i...

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.. .. .. .. of the net investment in each of the assets of the company to a)Calculation . carry out operations at the planned level on the target date. b)Calculation of the net worth of the company after adjusting the projected income of the company from the period of forecasting. c)Listing of the liabilities that can be relied upon without negotiation. d)Comparison of the projected assets with the total sources of funds,i.e liabilities and net worth. Interpretation of Projected Balance Sheet Items (a)Fixed Assets-As outlays of plant and machinery are generally planned beforehand, the amount of fixed assets can be estimated without much difficulty.However,adjustments are to be made for additions and sales of old assets along with the amount of depreciation. Other assets such as prepaid expenses, patents,goodwill etc will remain as they are unless it is specifically mentioned. (b) Current Assets. (i)

(ii)

(iii)

Cash-Usually a minimum amount of cash is to be maintained in hand for meeting various needs of the firm. It can also be a balancing or plug figure to equalize assets and liabilities. This is particularly the case when borrowings from banks are taken as fixed. Sundry Debtors (Accounts Receivable)-Sales budget can be used to forecast the magnitude of debtors. However it depends on the number of days credit is allowed to customers. It can be computed with the help of a formula; Inventories –The inventory level in relation to production programme is a unique item in the projected balance sheet. Itsestimate is made on the basis of turnover ratio or through careful estimates of purchase, production and selling schedules. It is computed as under: Stock turnover ratio=

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.. .. .. .. ©Liabilities . 1.Shareholders funds/networth:It consists of the amount of share capital and reserves and surplus(fixed assets plus current assets minus current and long term liabilities).Shareholders fund should be computed by taking into consideration the items such as fresh issue of shares, redemption of preference shares and retained earnings from profit as well. The profit figures are taken from the projected income statement. In case there is allocation of profit to reserve, it can be incorporated in the respective reserves. 2.Creditors-They can be estimated by analyzing schedules of purchases, payments for the period or by ascertaining the ratio of accounts payable with purchases or cost of goods sold. Creditors can be computed as follows:

3.Outstanding Liabilities-Outstanding or accrued liabilities can be analyzed by examining the pattern of wage payment, tax payments and interest obligations. Past and future data relating to these items should also be considered for this purpose. 4.Provision for tax and dividends: The projected balance sheet should be prepared only after providing proper provision for taxes and dividends.However,these items also depend on past and future data, the rate of tax and dividend etc. Having estimated all the components of the projected balance sheet,the financial an analyst should combine and present them in a balance sheet.Further,all the balance sheet items can be estimated by projecting financial ratios for the future. 42

.. .. .. .. Illustration 1: .

(b)Cash Budget Cash budget is one of the most important tools in the budgetary kit of the financial executive. It is prepared to estimate the expected cash receipts and payments during a specified period infuture. Thus cash budget is a forecast of how much cash will be required during a particular period in future. However the estimates are made on a day to day, week to week or month to month basis depending on the requirement of cash. The following are the main objectives of preparing a cash budget: (i)To ensure the availability of adequate amount of cash for thepurpose of various capital and revenue expenditures. To arrange cash in advance in the case of expected shortage of funds To employ surplus amount of cash if any in any profitable investment outside the business. Benefits of Preparing Cash Budget The various advantages which can be derived from the cash budget are as follows: 43

.. .. .. .. requirements: The cash budget provides a clear picture about the Cash . quantum of cash requirements at a particular moment of time. This helps the firm to make necessary arrangements for various purpose. Additional cash requirements: The cash budget also informs the firm the quantum of additional cash requirement during the peak period. It also suggests the way in which such funds are to be mobilized. Deficit or Surplus: The result of cash budget is either surplus or deficit cash. Thus surplus cash if any can be invested properly. Cash discount firm can derive the benefit of cash discount by making payments before the date as the surplus amount of cash can be known by the preparation of cash budget.

Methods of preparing cash budget A cash budget is prepared in any of the following ways:  Receipts and payments method  The adjusted profit and loss method  The balance sheet method For short term forecasting, thereceipt and payment method is very useful as the inflow and outflow of cash can be estimated by a proper analysis under this method. However the adjusted profit and loss method and the balance sheet method are useful for long term forecasting.

Receipts and payments method Under this method, all the all the anticipated cash receipts and payments during the budget period are considered. In other words the estimates of sales, purchases,productionetc form the basis of cash budget.It considers only cash receipts, regardless of their nature and period.Similarly,it recognizes payments irrespective of the particular point of time at which the liability for expenditure arises. Moreover the nature of cash payment is also 44

.. .. .. . irrelevant...But is needless to point out that the accrued expenses and incomes are not to be considered at all in this budget. Under this method, the budget is divided into two parts; receipts and payments. The receipts part of the budget is constructed in accordance with the sales budget, as the chief sources of funds are from sales. But the payments part of the budget is constructed as per other functional budgets. The cash budget prepared under this method provides the following information: Information as to the quantum of sales to be made and also about the timelag in the case of credit sales. Information about the raw materials to be bought. This is furnished from purchase budget. Information about the total amount of wages to be paid and the lag in payment of wages. Information about the amount to be paid for various overheads and the lag in payment of overheads. Information about the cost to be considered for acquiring fixed assets.This is required for preparing capital expenditure budget.

All other information relating to receipts such as issue of shares, overdrafts,etc and payments such as dividend,taxation,repayment of loans etc are also available from cash budget.

Illustration 1

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.. .. .. .. .

Adjusted profit and loss method Adjusted profit and loss method is practically useful for long term forecasting which attempts to indicate the effect of proposed long range plans such as acquisations,new product development and long range charges on the company’s balance sheet three,five,or even ten years in the future. The method is based on the assumption that profit is equivalent to cash and both cash and non cash transactions are considered.

Illustration: Balance sheet method In this method a budgeted balance sheet is prepared by recording all expected assets and expected liabilities except cash. In case the liabilities side is more than the assets side, the difference will be cash balance. On the contrary, ifthe assets side is higher than the liabilities side, the balance will represent bank overdraft. This method is highly useful for long term forecasting. Illustration 1.

OTHER METHODS OF FINANCIAL FORECASTING Percentage of sales method It is the simplest forecasting technique and is suitable for long term forecasting.

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.. .. .. .. is commonly used in estimating the financial requirements of This method . the firm based on forecast of sales. Under this method, each component of balance sheet item is expressed in terms of percentage of sales. Financial data can now be developed for projected sales at different levels.

BUDGETING Course objectives The main focus for budgeting is in planning. This represents steps taken by a business to achieve their desired levels of profits. This is in part by preparing a number of budgets which when put together forms an integrated business plan often referred to as master budget. The master budget is a vital management tool that communicates management plan throughout the organization, allocate resources and coordinate activities. In budgeting, we often identify a limiting factor; this being a factor at any given time effectively constraints the activities of the organization of the customers demand or production capacity, labour shortages or shortages of materials space or finance. Profit centre is a section or part of the organization that is accountable for both costs and revenues. Budget centre is a section of an entity for which control may be exercised and budgets prepared. Cost centre is an identifiable section or part of organization for which costs may be accumulated. Budget definition:

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.. .. .. .. expression of a plan of action prepared in advance of the A quantifiable . period to which it relates. -A quantitative statement for a defined which includes revenue expenses assets liabilities. It includes both financial and non financial aspects of the plan and it serves as a blue print for the organization to follow in the upcoming period ahead A budget may be prepared for the organization as a whole or for a department or as financial resources items of cash, capital expenditure etc. Budget provides for a plan or the forecast for the organization, aid in coordination in activities and facilitates control and planning. Planning is making of objectives and preparing budgets to achieve those objectives. This is accomplished by use of a master budget (fixed or static) Control represents the steps taken by management to change the likelihood that the plans set at the planning stage are attained and that all parts of the organization are working together towards that goal. Control is exercised by comparing activities cost revenues with amount in the flexible budget. A variance is the difference between budgeted results and the actual outcome. Afavorable variance arises when actual cost are less than the budgeted costs while unfavorablevariance arises when actual costs exceed the budgeted costs. Companies prepare long term strategic plans sparing a period of five to ten years that provide a roadmap for the future regarding potential opportunities as new products, materials or investments. They are then fine tuned and broken down into medium and and short term plans. Short term plans are more operational in nature and translate strategic plans into actions that are fairly concrete. They also contain specific objectives and goals.

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.. .. .. .. Budget Administration. . It refers to the appropriate administrative procedures put in place to ensure that the budget works appropriately. It should be tailored to a particular organization and its circumstances. There are three elements in budget administration: Budget committee Budget Reporting Budget timing A budget committee overseas the preparation of a budget. Budgets should not just be handed down as top management final word. Budget figures and estimates are usually more helpful when developed through a bottom-up approach in which every department prepare their own budget which is then handed over to budget committee for scrutiny, moderation and approval. The committee is made up of departmental heads and other executives who are responsible seeing that budgetary amounts are realistic. There is need for continued communication from the originating departments and the budget committee to ensure that both parties accept the budget and estimates are reasonable, attainable and desirable. Budget reports contain relevant information that companies actual results to planned objectives. They may be prepared at any time and for any period. They highlight variances between actual and budgeted targets which may call for investigation and if need be remedial action.

Steps in budget process. 1) 2) 3) 4)

.Communicating details of the budgeting policy. Determine the factors that restrict performance. Prepare the sale budget. Prepare the initial budget from the sub-units of the organization. 49

.. .. .. .. Negotiate the budget with supervisors. .

5) 6) Coordination of review of budgets. 7) Summarising the section budgets into a master budget. 8) Budget review done periodically.

Types of Budgets. 1. Strategic plan-sets the overall goals and objectives of the organization. 2. Long range plans-Result from strategic plan and produces forecast financial statements sparing five to ten years. Such plans involve making decisions of design and allocation of new plant, acquisition of items and buildings, long term commitments etc 3. Capital Budgets –Details the expenditure for facility requirement, new product and other long term investments. 4. Master Budget- One year or twelve months, summarize all the activities of all sub-units of an organization across all the functions e.g.finance, production 5. Continuous or Rolling budget – Common form of a master budget that adds a month or a quarter 6. Fixed budget –one designed to remain unchanged irrespective of the volume of output achieved the period it relates to.It is therefore based on a single predetermined amount of sales or output. The purpose of a static budget is to help managers in planning future activities the organization. 7. 7. Flexible budgets-Designed to adjust to the permitted cost levels so as to suit the level of activity that is attained. Designed to recognize various behavior patterns change and change of volume of activity. It’s a report based on predicted amounts of revenues and expenses corresponding to the actual level of output. Unlike fixed budget flexible budget is prepared after the periods activities are are complete. In order to prepare it, one must analyze cost as fixed or variable elements so that the budget may be flexed or changed according to the level of activity. The purpose of a flexible budget is

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.. .. .. .. managers evaluate past performance which are used in the to help . control process. Components of a master budget. i.

ii.

Operating budget –focuses on the income statement.comprises of sales, purchases,and production budget, cost of sales budget, operating expenses and budgeted income statement. Financial budget –represent that part of the master budget focusing on the effect of operating budget and other plans which involve cost.

Approaches to overcoming Problems in budgeting 1. 1.Zero based budgeting 2. 2.Activity based budgeting 3. 3.Rolling or continuous budgeting Zero based budgeting All activities are re-evaluated every time a business is formulated. Each trial budget begins with the assumption that the function doesn’t exist and any change in cash must be justified by incremental benefit. Useful for discretionally spending eg advertising costs.

Advantages 1) It results in more efficient resource allocation to activities especially when properly carried out. 2) It focuses attention on value for money and makes explicit the relationship between resources used and output. 3) It helps in furthering a questioning attitude and eliminates non productive operations. 4) It also provides a systematic way of challenging the status quo –it obliges the organization to examine alternative activities, existing

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.. .. .. .. patterns. Provides a tool that responds tochanges in the behavior . environment. Demerits Not always acceptable to staff and trade unions who may prefer cozy but expensive status quo.They may view a detailed examination of alternatives as a threat instead of challenge. ZBB is difficult to sell to managers for two reasons: 1. Incremental costs and benefits over alternative methods can lead to quantify accuracy. 2. Trade unions will restrict management ideas that change ways in which budgeting is done. 3. The approach is time consuming and features a lot of paperwork.

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.. .. .. .. CHAPTER . THREE VERTICAL AND HORIZONTAL RELATIONSHIPS AMONG PARAMETERS OF FINANCIAL STATEMENTS Objectives: at the end of the lecture the student should be able to Identify the major changes (turning points in trends amounts relationship)

Common size analysis Common size analysis involves expressing comparisons in percentages for example if cash is ksh. 40,000 and total assets is ksh. 1,000,000, then cash is 4% of total assets.

The use of percentage is usually preferable to the use of absolute figures.

e.g if a firm A earns shs. 10,000 and firm B earns ks.1,000 which is more profitable? Firm A probably your response. However, the total owners equity of A is ksh. 1000,000 and B’s is ksh. 10,000 the return on owners equity is as follows

Firm A

firm B

Earnings

sh. 10,000 = 1%

sh. 1,000 = 10%

Owner’s equity

sh. 1,000,000 53

sh. 10,000

.. .. .. .. . The use of common size analysis can make comparisons of firm’s of different sizes much more meaning since the numbers are brought to a common base; perfect. Vertical analysis In vertical analysis, a figure from a year is compared with a base selected from the same year. Eg.If advertising expenses were ksh. 1,000 in 1992 and sales were ksh. 100,000 the advertising would be 1% of sales.

Horizontal analysis In horizontal analysis a dollar/shilling figure for an account is expressed in terms of that same account figure for a selected base year. For example, if sales were ksh. 400,000 in 1991 and ksh. 600,000 in 1992 then sales increased t 150% of the 1991 level in 1992 an increase of 50%.

RATIO ANALYSIS

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.. .. .. . Financial ..ratios are usually expressed in percentages or a ration is defined as indicated quotient of two mathematical ‘times’ expressions. Types of ratios 1. Liquidity ratios – measures a firm’s ability to meet its current obligations. They may include the ratios that measure the efficiency of the use of current assets 2. Leverage ratios – they are capital structure ratios. They measure the financial risk. The degree of protection of supplies of long-term funds 3. Activity rations (turn over ratios) evaluate the efficiency with which assets are utilized. 4. Profitability ratios- measure the earning ability of a firm including the use of assets in general

-In financial analysis, a ratio is used as a benchmark for evaluating the financial production.

Standards of comparison Past ratios – calculated for the same firm

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.. .. .. .. values – selected firms at selected point in times Competition . Industry – industry to which the firm belongs Projected ratio – ratios from projected or proforma financial statements of the same firm. Ratio analysis is a very useful tool to raise relevant questions on a number of managerial issues. It provides clues to investigate those issues. It provides clues to investigate those issues in detail. However, caution needs to be applied while interpreting ratios as they are calculated from the accounting numbers. Accounting numbers suffer from accounting policy changes arbitrary allocation procedures and inflation.

Liquidity ratios Current ratio = current Assets Current liabilities Quick ratio = current assets – inventory Current liabilities

Internal m...